Sunday, September 30, 2012

If we look at what's skyrocketed in price (healthcare, college tuition), we find they are government funded and supported. This is not a coincidence.

Inflation is generally viewed as a monetary phenomenon (print money excessively and you get inflation), but let's use a very simple definition: any loss of purchasing power. If your income buys fewer goods and services, for whatever mix of reasons (geopolitical, weather, monetary, fiscal, etc.), that's inflation "on the ground."

Consider this breakdown of the components that together make up the standard measure of inflation, the Consumer Price Index (CPI): (courtesy of dshort.com) What are the obvious major sources of inflation? Energy, medical costs and college tuition.

Here's an eye-opening look at medical costs and college tuition, also courtesy ofdshort.com:

What differentiates medical and college costs from everything else? The Federal government's direct role in these markets. The Central State directly spends over $1 trillion a year on Medicare and Medicaid, and controls private spending with rules and regulations.

As for college costs: could their incredible expansion have anything to do with the Central State backing $1 trillion in student loans?

The Federal government controls much of the economy, directly or indirectly. It influences agriculture prices with price supports and regulatory controls, it influences the cost of housing with gargantuan subsidies (FHA and VA loans) and has basically taken over the entire mortgage market in its effort to re-inflate the housing bubble.

But it is striking that the highest inflation is occurring in precisely those sectors dominated by government spending: medical and college costs.

I was alerted to this correlation by correspondent David P., who wrote:

Inflation is centered in particular markets - not finance, housing or small business, but wherever the government spends money: Schools, food, energy, medical care.

This is of a piece with the previous post on the Federal Reserve's policy of supporting Federal spending by monetizing Treasury debtWhy QE May Not Boost Stocks After All (September 26, 2012). In other words, the Fed doesn't necessarily create inflation across the entire economy (Why QE Won't Create Inflation Quite as Expected) by printing money; it creates inflation in government-funded sectors by monetizing Treasury bonds that enable massive Federal spending.

Government spending is by definition unhindered by market forces; having a monopoly on coercion, taxation and selling Treasury bonds to the Federal Reserve means you get to spend money without worrying about price or other market functions.

Government spending that funnels huge sums of money into cartels--for example, the sickcare and higher-education cartels--directly supports monopolistic pricing, which then drives costs higher regardless of the money supply expanding or contracting. This is the basic function of the Statist monopoly capital partnership that dominates our neofeudal economy.

Where the Fed has succeeded is in raising expectations of inflation that then drive speculative bets on higher prices. Part of the "don't fight the Fed" belief system is if the Fed wants inflation, it will get it. And if that's the case, then why not buy oil/gold/silver now before prices shoot higher?

The price of oil in the U.S. is influenced by many factors--geopolitical, currency, technology, policy, etc. Nonetheless, the rough correlation between base money supply and the price of oil in dollars is noteworthy:

It's also worth recalling that the Federal government itself is a major consumer of oil, as the Pentagon alone consumes as much oil as a small industrialized nation.

Government spending and intervention fuel inflation, and the Federal Reserve enables that spending and inflation by monetizing Federal deficits. Raising expectations of inflation has powered oil higher on speculative buying, but it's difficult to generate economy-wide inflation when wages are declining (courtesy of dshort.com):

Eventually, declining wages lead to demand destruction, as households consume fewer goods and services. But inflation that is being driven by government spending will not decrease, as the demand is being supported by a borrow-and-spend Central State supported by a monetize-Federal-debt-til-Doomsday Federal Reserve.

We are like passengers on the Titanic ten minutes after its fatal encounter with the iceberg: though our financial system seems unsinkable, its reliance on debt and financialization has already doomed it.We cannot know when the Central State and financial system will destabilize, we only know they will destabilize. We cannot know which of the State’s fast-rising debts and obligations will be renounced; we only know they will be renounced in one fashion or another.
The process of the unsustainable collapsing and a new, more sustainable model emerging is called revolution.Rather than being powerless, we hold the fundamental building blocks of power. We need neither permission nor political change to liberate ourselves. A powerless individual becomes powerful when he renounces the lies and complicity that enable the doomed Status Quo’s dominance.

Thank you, John H. ($5/mo), for your splendidly generous subscription to this site--I am greatly honored by your support and readership.

Robin spotted Kylie standing outside the doors of the appointed cafe, and his heart rate leapt in anxious anticipation. For if there was a more delectable young woman on the planet, Robin could not imagine her; Kylie's dark chestnut locks swirled fetchingly in the gusty breeze, and her fluttering short black skirt left plenty of firm brown leg delightfully visible. As each nervous hopeful feared, the other was equally nervous and on their best, which is to say awkwardly tentative, behavior. After a strained greeting, the pair ordered mochas and sat down at a table facing the side street. Kylie took out her cell phone and set it to vibrate so no incoming calls would disturb their meeting, and each fidgeted as the cold air of doubt descended over their table. Trying to break the chilly reserve, Robin set the toaster and posters on the chair beside him and joked, "I feel like I'm transporting the crown jewels." "Me, too," Kylie laughed and then spoiled her smile with a wince. "What's wrong?" Robin asked solicitously, and she replied with self-effacing chagrin. "I stupidly pulled something in my shoulder this afternoon playing tennis, and the pain pills I took have had zero effect." "I took a summer of physical therapy courses after my freshman year in college," Robin said. "I had this crazy idea that I could make money as a physical therapist while I finished my degree in marketing." "It didn't work?" "No," he said with a shrug, "But I did learn a lot about injuries." Glancing at her, he said, "Do you mind if I take a look at your shoulder?" Her expression turned coy and she said, "Don't tell me you're going to suggest coming over to my place to give me a full-body massage." Robin grinned ruefully. "No, I meant right here." Kylie looked askance and he said, "I'll just put my hand on your shoulder blade to see if I can feel any strained muscles." Concluding his offer might ease their second-date anxiety, Kylie consented. As Robin took up position behind her he joked, "Of course like any patient you will need to take off your clothes—but only to the waist." "I suddenly feel those pain pills working," she countered, and at this hint of humor in their voices, the pixies of their first meeting returned. Placing one hand firmly on her shoulder, Robin lifted her right arm and she sucked in her breath at the resulting stab of pain. "You're very tight right here," he remarked, and pressed his thumb gently into her flesh. "It feels like there's an iron rod in there." The pressure relieved some of her red-hot hurt, and she murmured, "That feels better." As Robin kneaded the inflamed muscles with his thumb, he luxuriated in the scent of her hair and the golden-brown swath of exposed neckline left bare by the collarless blouse. Please invite me over to continue the massage, he implored her silently, even as he knew a careful girl like Kylie would never dream of permitting such intimacy on a second date. "Relax your neck," he told her in a soothing voice. "Just ease your head forward, yes, like that." Gently pulling her hair over her other shoulder, Robin congratulated himself on extending a very delightful proximity. "Better?" he asked. "Yes," she murmured, and against his wishes he reckoned discretion would best be served by limiting his laying on of hands. Sitting down across from her, he was rewarded with a much more radiant Kylie than the one who'd sat down full of tension a few moments before. "You did learn something," she conceded. "It does feel better." "Glad to be of service," he said with a mock bow, and then glanced at the packages beside him. "I guess we better conduct the business." "And what serious business it is," she replied. "I've been instructed to test the appliance lest your Dragon Lady friend pass a dead toaster off on us." Robin chuckled. "They really are alike. She told me to check for the same thing." Glancing round at the walls, Robin added, "Too bad there's no outlet around." "There's always one in the bathroom," Kylie said, and the absurdity of the setting made both negotiators grin. Taking up the bag containing the precious T-20Z, Robin said, "To the bathroom we go." By balancing each toaster on the edge of the sink, the pair completed their test in the unisex restroom. To their mutual relief, each toaster was ready to accept two slices of soft cool bread and transform them into crisp browned toast. Jokes were bandied back and forth about the rather tame graffiti scrawled on the walls, and the young couple returned to their seats with their ears full of angelic whispering. The posters were duly checked for authenticity and damage, and Kylie admitted she'd never heard of the two movies advertised in the garish posters being given to Ross: Blue Bikers Take Borneo and Kama Sutra Cadillac. "I think they fall into the category of 'so bad they're good,'" Robin joked. "They're probably worth a small fortune." The wind had stiffened, and as the trees outside the cafe swayed, Robin added, "I don't feel much like going out into that," and Kylie demurred to the implicit invitation to stay longer. Their conversation roamed from their work—or in Kylie's case, the lack of it—to their university days, childhood, families and eventually round to the present. "I'm just getting by now," Robin confessed, and then brightened. "If I had a partner, I could take over my mentor's route. He wants to retire, and no wonder—he also covers organic goods and restaurant supply." "Why don't you? I mean, take a partner?" Robin's enthusiasm deflated like a punctured birthday balloon. "That's the rub. I like being out with customers, and most of the new workload would be back office stuff I loathe. And the partner would have to work without pay at first until we paid off my mentor and built the accounts up. We'd have to really trust each other, and, well, trust is a rare commodity these days." Kylie nodded appreciatively, and then gazed at Robin with a faintly quizzical expression. "So where exactly do you live?" "In the ground-floor flat below Alexia." Bowing to the expected symmetry in personal information, Kylie confided that she lived across the hall from Ross, on the first floor of their rooming house. "I still don't know what he looks like," Robin remarked, and Kylie tilted her head and smiled most endearingly. "Let's just say he looks better in drag than he does in an old Ohio State sweatshirt." "Poor guy," Robin said sympathetically. "You and this Dewey are probably his only friends." Kylie looked down at the table and toyed with her mocha-stained white coffee cup. "I really don't know what he'd do without his dream of going to Vegas." This sparked Robin's curiosity, and so Kylie sketched the story of Ross's crushing defeat online for the coveted T-20Z, his machinations to wrest it from Alexia's grip and his dreams of glory at the Las Vegas small-appliance show. She told it so entertainingly that both were surprised to find the storm-laden sky dark by the time their conversation ebbed. The time to part was at hand, and Robin looked at her with a sudden intensity. "Tell me the truth—will you meet me for lunch next week? If you say no, it's okay—I won't melt into Jell-O." Amused by the seriousness of his query, Kylie grinned and said, "Oh, I love Jell-O, especially the orange flavor. And yes, I will meet you for lunch next week." A jolt of relief lit Robin's expression and he asked, "Then shall we set a date? I'm here in the East Bay every week on sales calls." Kylie successfully hid her joy behind a cool aplomb. "Gosh, my schedule is just so packed, what with appointments at the unemployment office and all. How about next Wednesday?" "Wonderfulness," he replied, and then arose to accompany her to the door.

A note of thanks to those who buy the book: As an independent writer, book sales are a substantial part of my income. I receive no funding from a university, trust fund, hedge fund, think-tank or government agency. I self-publish my books as a financial necessity, as the small royalties (5% to 7.5% of the retail price) paid by publishers cannot support me during the long months it takes to write a book. Your purchase makes it possible for me to continue sharing ideas on the blog and in my books. Thank you.

Thursday, September 27, 2012

"Beautiful deleveraging" is the policy goal, but what we might get is "ugly inflation."

In a world of rising sovereign debts and an overleveraged, over-indebted private sector, history suggests there are only three possible ways out: gradual deleveraging, defaulting on the debt, or printing enough money to inflate away the debt.

Ray Dalio recently described the characteristics of a “beautiful deleveraging” in which equal doses of austerity, write-downs, and inflation gradually lighten the load of impaired debt. This might be called the Goldilocks Deleveraging, as the key feature of this “beautiful” solution is that each component is “not too hot, not too cold” – inflation is modest, write-downs of bad debt are gradual, and austerity is not too severe. Given enough time, the leverage and debt are worked off without requiring any structural change to the Status Quo.

Understandably, the Status Quo has embraced this solution for the appealing reason it doesn’t change the power structure at all. Everyone currently in charge remains in charge, and everyone who owns outsized wealth continues owning outsized wealth. Rather than falling onto the politically powerful “too big to fail” banking sector, the pain of deleveraging is spread over the entire economy. There is no such thing as painless deleveraging, so the “solution” is to distribute the pain over hundreds of millions of people. That’s what makes it “beautiful” to the Status Quo: It doesn’t cost them either their power or their wealth.

The Status Quo in Japan has pursued this strategy for 20 years, and the Status Quo in Europe and the U.S. have pursued it for the past four years, ever since the global financial system imploded in 2008.

Unsurprisingly, the conventional view is that it’s working "beautifully". Housing has bottomed, stocks have doubled since their March 2009 lows, households are slowly deleveraging, inflation is modest, and growth is sluggish but steady. All we need to do, we’re told, is stay the course for a few more years, and the stage will be set for a return to the rapid growth of the bubble years.

Central Banks to the Rescue

The core mechanism of this “leave the Status Quo intact” solution is that central banks conjure money out of thin air (i.e., “print money”), which they use to then buy impaired bank debt (such as delinquent mortgages) and sovereign debt (such as the bonds of Spain, Italy and the U.S.)

This transfers impaired private-sector debt and sovereign debt to the central banks’ balance sheets, where they are safely sequestered from price discovery. The central banks keep these questionable assets on the books at full value, and the Status Quo is happy. The banks trade their risky impaired assets to the central bank for cash, which they can use to speculate or originate new loans, and governments can continue to run monumental deficits because the bonds they issue are purchased (i.e., “monetized”) by central banks.

Central bank balance sheets swell with phantom assets, but nobody cares, as the debt no longer burdens private banks and governments are free to borrow and spend.

It all seems too good to be true, and so skeptics ask:If this deleveraging is so 'beautiful', why are the developed economies sliding into recession? If this deleveraging has worked so well, why are governments still running unprecedented deficits even as hiring, production, and lending all weaken?

Skeptics of the official “happy story” see plentiful evidence that the beautiful deleveraging of central-bank monetization is simply papering over the structural rot at the heart of the financial/political Status Quo – the shadow banking system, the risk-laden derivatives trade, the “fraud-is-our-business-model” mortgage securitization industry, and so on.

Somebody Has to Pay the Price

Skeptics reviewing history find few examples of painless deleveraging and many examples where over-indebtedness and central bank money-printing lead to a stark choice: Either accept high inflation as a way of inflating debts away, or renounce sovereign debt and devalue the currency.

Neither “solution” is ideal nor beautiful. Inflating away debt by depreciating the currency (via money-printing) allows debtors to pay debt with “cheaper” money, but inflation savagely erodes financial wealth. If we earn $100,000 an hour, our $100,000 mortgage can be paid off with one hour’s labor, but our $100,000 in savings will only buy three gallons of gasoline – the same number of gallons an hour’s labor bought back when we earned $12 an hour. We can print money but not oil.

If a nation renounces its debt, everyone who owns the sovereign bonds loses some or all of their investment, and the currency loses value as global traders and investors recalibrate the value of the currency. Once the currency is devalued, imports such as oil rise steeply in cost, leaving less household income to be spent or invested. Consumers pay the price of devaluation.

In other words, there is no painless deleveraging. The price has to be paid by someone, and so the battle behind the façade of “beautiful deleveraging” is over whom the cost will be transferred to.

If the government absorbs all the banks’ bad debts and runs large structural deficits, the cost is transferred to the taxpayers. If the central bank prints money in excess in order to absorb the banks’ bad debts, inflation rears its head, and everyone with savings and who earns wages pays the price via a loss of purchasing power.

Though it is dismissed as “impossible” – and it is politically impossible, as the banks have captured the machinery of governance – banks could be forced into insolvency and their assets liquidated on the open market. This would clear the decks of impaired debt and distribute the losses to those who owned the impaired debt: pension funds, insurance companies, hedge funds, individuals, etc. Every owner would share equitably and proportionately in the losses.

But this would upset the Status Quo’s power and wealth-sharing arrangement, and so it is dismissed as unworkable.

Beautiful and Ugly Inflation

A key mechanism in beautiful deleveraging is beautiful inflation at an annual rate of, say, 3% (gosh, isn’t that the Federal Reserve’s target?) that steals 3% from the purchasing power of the currency while depreciating debts by the same 3%.

In a decade, both the value of the debt and the currency have fallen by over 30%, but the loss of purchasing power has been so gradual that the losers – wage earners, consumers, savers, and owners of the devalued debt – don’t feel enough pain to protest.

Truly beautiful inflation combines low-interest fixed-rate debt, wage and price inflation, and a stable currency. If wages and prices are both inflating at 10% a year, wage earners don’t feel any pain as their income rises in tandem with the cost of goods and services. Any mismatch – say wages rise 8% a year while prices rise 10% – is slight enough that the erosion won’t trigger any political fallout. With a stable currency, imports don’t cost more, either.

Meanwhile, low-interest fixed-rate debt is being wiped out at a rapid clip. In a decade of 10% annual inflation, the debt has lost roughly two-thirds of its value. Wages have doubled at the end of ten years, while existing mortgage payments have remained unchanged.

Debtors have an easier time servicing debt, and inflation has magically deleveraged the household. As the value of people's old debt declines and their nominal income rises, they can afford to take on more debt.

Banks can issue new debt to the newly deleveraged households, earning fat transaction fees and securitizing the newly issued debt so that it can be offloaded to investors.

The government also benefits, as rising nominal wages push taxpayers into higher income brackets, swelling government revenues. Everybody wins. Households get to consume more goods and services, banks get to originate more debt, and the government rakes in more tax revenues. No wonder the Status Quo is pursuing beautiful inflation.

Two things can turn beautiful inflation into ugly inflation: Wages don’t inflate along with prices and the currency depreciates as money is printed excessively. This might not matter for a nation that is a net exporter of goods and services. But for nations that import essentials such as oil and grain, this is a catastrophe, as wages are flat while the cost of imported energy and food skyrocket. Households have less money to spend, and servicing debt becomes increasingly burdensome.

This is ugly inflation: Household incomes decline in real terms, the rising cost of essentials squeezes discretionary spending, and servicing debt becomes more difficult. Households not only cannot afford new debt; many have to default on debt just to survive. Bank lending falters and defaults rise, eroding banks’ solvency. As household incomes stagnate, government tax revenues decline as well.

In ugly inflation, everybody loses.

Welcome to the United States of Ugly Inflation. Real household income (i.e., adjusted for official inflation) has declined 8% since 2007; the cost of oil, medical care and higher education has climbed; and government revenues have stagnated even as demand for government services has increased.

As a result, the entire beautiful deleveraging scenario is at risk. Austerity carries a high political cost, and central bank printing appears to be fueling ugly inflation. Behind the “happy story” façade, falling incomes mean that household deleveraging is an illusion, along with bank solvency.

What else is at work here? Where is this leading? Possibly to destinations many reading this may not expect.

In Part II: Why the U.S. Dollar, Counterintuitively, May Strengthen from Here, we explore several key (and under-appreciated) mechanisms. Reality rarely unfolds in a tidy linear progression (if A > than B > than C) and usually involves more factors than we think to put into our forecasting models. There are several key market influences (e.g., the price of oil) and non-market influences (e.g., sovereign interests) capable of constraining central banks' ability to print money. And as a result, the currency devaluation that many see as being baked into the cake may not materialize.

We are like passengers on the Titanic ten minutes after its fatal encounter with the iceberg: though our financial system seems unsinkable, its reliance on debt and financialization has already doomed it.We cannot know when the Central State and financial system will destabilize, we only know they will destabilize. We cannot know which of the State’s fast-rising debts and obligations will be renounced; we only know they will be renounced in one fashion or another.
The process of the unsustainable collapsing and a new, more sustainable model emerging is called revolution.Rather than being powerless, we hold the fundamental building blocks of power. We need neither permission nor political change to liberate ourselves. A powerless individual becomes powerful when he renounces the lies and complicity that enable the doomed Status Quo’s dominance.

The Fed can create money but if it doesn't end up as household income it is "dead money."

In the consensus view, the Federal Reserve's unlimited quantitative easing (QE3) programs will do two things: 1) boost stocks and other "risk on" assets and 2) generate inflation. The two follow-on effects are related, of course; gold and other hard assets are rising in anticipation of higher inflation.

But all is not quite as it seems when it comes to the inflationary effect of creating money. I'm going to cover a lot of ground here so buckle up and grab your favorite stimulating beverage.

Let's use some examples to illustrate key features of the relationship between money creation and inflation. Let's say a central bank prints $1 trillion in cash currency, digs a big hole and buries it. Does that $1 trillion in new money cause inflation? No, because it never got into the hands of people who might trade it for goods and services in the real world.

Recall that the premise of monetary inflation is straightforward supply and demand: when money is abundant and goods are scarce, the price of goods rises as abundant demand (everybody has lots of cash or credit) meets limited supply (limited oil, gold, grain, etc.) in an open marketplace.

Let's say the Fed electronically creates $1 trillion and metaphorically buries it in some account where it sits as "dead money." It cannot trigger inflation because it isn't reaching the hands of people who might use it to buy scarce goods and services.

Let's also recall that money is destroyed, not just created, when assets fall in value and bad debt is written down. Consider a house purchased for $350,000 at the top of the real estate bubble with a $50,000 cash down payment and a $300,000 mortgage. The owner defaults and the house is sold for $150,000. The $50,000 down payment was cash; it was not “on paper.” It has not been transferred to someone else; it has vanished.

The same can be said of the $150,000 the bank lost on the mortgage. The bank’s cash reserves (capital) take a $150,000 hit. That was real money, too, and it wasn’t transferred to someone else; it disappeared. Thus $200,000 of real money has been destroyed.

To the degree that immense overhangs of bad debt are slowly being written off, money is being destroyed. If the Fed “prints” $500 billion a year, and write-downs erase $500 billion, the money supply hasn’t expanded at all.

The Fed bought $1.1 trillion in mortgage-backed securities as part of its earlier QE interventions in 2009-10. Notice that the $1.1 trillion has already fallen to $850 billion--a decline of $250 billion in just a few years. The loans were paid down, paid off or written off.

According to the Balance Sheet of Households (federalreserve.gov), home mortgages have declined from $10.3 trillion in 2009 to $9.7 trillion in 2012. Credit is being destroyed in the primary asset of the American household, their home: one-third have zero equity (underwater), millions more have insufficient equity to borrow against/extract, and millions more are not creditworthy enough to borrow more, even though they have equity in their house.

The decline in asset values has destroyed money and credit.

The general assumption is that the Fed buys dodgy MBS from banks which then take the money and dump it into the stock market, pushing stocks higher. This assumption fails to consider the weak balance sheets of banks, which will soon be required to post some collateral behind their trillions of dollars of outstanding derivatives.

The favored collateral is U.S. Treasury bonds, and so banks may be constrained by their need to build reserves against future writedowns. They may end up buying Treasuries as collateral rather than gambling in the equities market. The newly created money may end up as "dead money" in reserves, not cash propping up equities.

A number of indicators suggest money is not flowing into hands which might actually trade it for goods and services. Consider money velocity, courtesy of Chartist Friend from Pittsburgh:

The velocity of money buried in a hole is zero. The velocity of hoarded money is also zero. The velocity of credit that is never used (i.e. no money is actually borrowed and spent) is also zero. Money that is created but which has zero velocity cannot spark inflation.

If money were flowing into real-world households, we'd expect to see household incomes rise. Instead we see falling incomes. Here is the real (adjusted) income for the 45-54 year old age bracket, when lifetime earning tend to peak (courtesy of dshort.com):

If there is net expansion of the base money supply, it isn't finding its way into household incomes where it could be spent on real goods and services.

As for the "wealth effect," it only affects the 5% who own enough equities to make a difference. That narrows the whole "wealth effect" to 7 million people out of 142 million workers.

Interestingly, the top 5% is the only demographic that is actively deleveraging, i.e. reducing debt rather than borrowing more:

Add all this up and here's what we get: money is not just being created by the Fed, it's being destroyed by declines in asset valuations and writedowns of impaired debt. Credit may be expanding but the top rung of households is paying down debt, not borrowing more, and the bottom 95% are unable to add much to their already staggering debt load.

Incomes are declining, providing a smaller base for both spending and borrowing. The top 5% may be experiencing a "wealth effect" as stocks soar but 7 million people cannot levitate the entire $15 trillion U.S. economy much while the incomes of the 137 million other workers are stagnant or down.

Money velocity is plummeting and banks are hoarding Treasuries as much-needed collateral.

It's difficult to see how these forces could generate inflation. There may be new money and credit being created, but very little of it is flowing to households whose spending in the real economy drives inflation.

We are like passengers on the Titanic ten minutes after its fatal encounter with the iceberg: though our financial system seems unsinkable, its reliance on debt and financialization has already doomed it.We cannot know when the Central State and financial system will destabilize, we only know they will destabilize. We cannot know which of the State’s fast-rising debts and obligations will be renounced; we only know they will be renounced in one fashion or another.
The process of the unsustainable collapsing and a new, more sustainable model emerging is called revolution.Rather than being powerless, we hold the fundamental building blocks of power. We need neither permission nor political change to liberate ourselves. A powerless individual becomes powerful when he renounces the lies and complicity that enable the doomed Status Quo’s dominance.

Wednesday, September 26, 2012

What if the Fed throws a QE equity-ramp party and the fireworks fizzle?

If there is one dominant consensus in the financial sphere, it is that the Federal Reserve's $85 billion/month bond-and-mortgage-buying "quantitative easing" will inevitably send stocks higher. The general idea is that the Fed buys the mortgage-backed securities (MBS) and Treasury bonds from the banks, which turn around and dump the cash into "risk on" assets like equities (stocks).

This consensus can be summarized in the time-worn phrase, "Don't fight the Fed."

This near-universal confidence in a QE-goosed stock market is reflected in the low level of volatility (the VIX) and other signs of complacency such as relatively few buyers of put options, which are viewed as "insurance" against a decline in stocks. The usual sentiment readings are bullish as well.

But what if QE fails to send stocks higher? Is such a thing even possible? Yes, it does seem "impossible" in a market as rigged and centrally managed as this one, but there are a handful of reasons why QE might not unleash a flood of cash into "risk on" assets every month from now until Doomsday (i.e. December2015--the Mayans made one teeny addition error in Column 13).

1. Bullish sentiment. Though Mr. Market has been chained and whipped by central planning, he still harbors a mighty resistance to rewarding the majority in any trade, and with most traders firmly on the bullish side of the boat, Mr. Market might break free of the Fed's chains long enough to capsize the boat.

As the saying goes, complacency leads to volatility, and stability leads to instability. Not all cycles can be voided by central planning, until Central Planners own 95% of every market (which seems to be the direction we're going here).

2. The technical case for QE yielding diminishing return.The Keystone Speculator (among several analysts pursuing the same line of inquiry) made a compelling case for a Fibonacci sequence playing out as each QE is launched:

Starting with the time, QE1 was a 13-month pump, so note the beauty in the Fibonacci sequence occurring; 13, 8, 5, 3. Thus, the current 3-month rally would already have achieved its target based on this metric. For the point moves and percentages, continuing along in the sequence would target about a 20% rally for the current QE3 pump, with about a 250-point move off the 1270-ish bottom which places price in the 1520's target area. "Don't fight the Fed" is the mantra, but the current rally appears far along already.

In other words, the length and rise of each QE-goosed rally diminishes with each QE. If this pans out, the QE3 rally is within a few weeks of topping out and reversing.

3. The Fed has trained traders to front-run its decisions. The Fed has played a masterful PR game of describing its next round of intervention for months, keeping markets aloft in anticipation of the "free money" flood.

In one of the unintended consequences that central planning excels in producing, the Fed has trained traders in Pavlovian fashion to front-run "risk on" assets, i.e. buy stocks before the Fed actually announces its latest market manipulation. As a result, stocks have already run up strongly so the "announcement" bounce is modest; everybody tempted to be bullish is already all-in, and disbelievers are wary of jumping in on the downside of "buy the rumor, sell the news."

4. The Fed has no surprises left. The market loves surprises, especially lavish gifts of free money from central banks, and now, 3.5 long years after the March 2009 lows in global equities, there are no more surprises left--unless the outright purchase of stocks by the Fed counts as a surprise. Interest rates are already near-zero, the Fed already owns a significant percentage of all long-term Treasury bonds (see The Fed Now Owns 27% Of All Duration, Rising At Over 10% Per Year, Zero Hedge), and it already bought $1.1 trillion in MBS and will keep buying more dodgy mortgages.

So what's left to wrap up and deliver to a market addicted to free-money surprises every few months? Nothing.

5. Correspondent David P. explained the real mechanism at work in QE3--the enabling of fiscal "nearly free money" spending. The Fed creates money electronically and uses the cash to buy $45 billion of Treasuries every month. Since the Treasury now holds a preponderance of short-term bonds to keep interest rates down (as explained by Zero Hedge), it must issue an insane amount of bonds every month to roll over existing short-duration bonds and fund the Federal government's $1.2 trillion deficit.

The only way the Treasury can get away with issuing trillions of dollars in bonds every year is if somebody buys and holds a big chunk of them, i.e the Fed. Here is David's explanation:

While Fed money printing doesn't make it to the marketplace, Federal government spending does, and Fed monetizing makes it so that Treasury borrowing doesn't negatively impact treasury markets and so Treasury rates don't increase.Fed directly enables the Treasury to spend its 8% GDP of borrowed money each year. That money goes right into the economy, no ifs, ands, or buts. And we know Bernanke is forever talking about how effective "fiscal policy" is - and he's enabling it directly through his monetization.
The Federal government gets to borrow half a trillion effectively for free in perpetuity as the Fed effectively says, "Don't worry about $500 Billion of that 'fiscal cliff.'"

In other words, the pathway of the freshly printed money goes from the Fed to Treasuries and through deficit fiscal spending into the real economy. The amount of "new free money" flowing into equities may be a lot less than the consensus believes, as $500 billion of it has already been committed to enabling Federal deficit spending on a monumental and seemingly permanent level.

We are like passengers on the Titanic ten minutes after its fatal encounter with the iceberg: though our financial system seems unsinkable, its reliance on debt and financialization has already doomed it.We cannot know when the Central State and financial system will destabilize, we only know they will destabilize. We cannot know which of the State’s fast-rising debts and obligations will be renounced; we only know they will be renounced in one fashion or another.
The process of the unsustainable collapsing and a new, more sustainable model emerging is called revolution.Rather than being powerless, we hold the fundamental building blocks of power. We need neither permission nor political change to liberate ourselves. A powerless individual becomes powerful when he renounces the lies and complicity that enable the doomed Status Quo’s dominance.

Thank you, Robert G. ($5/month), for re-subscribing to this site-- I am greatly honored by your continuing support and readership.

Tuesday, September 25, 2012

Sensitivity to domination, aggression and loss of face run deep in East Asia.

Longtime correspondent Cheryl A. asked me to comment on the dispute between China and Japan over the Senkaku/Diaoyu Islands. I am happy to oblige, as this raises a great number of deeply intertwined issues that are playing out in Asia.

Let's start by noting the "stranger than fiction" absurdity of privately owned islands in ambiguous-nationality waters off China--the scenario of Bruce Lee's classic martial arts filmEnter the Dragon. The plot revolves around an ex-Shaolin monk engaged in the drug and prostitution trade who has acquired a private island with murky nationality where he stages martial arts competitions of "epic proportions."

Despite the resemblance to fiction, the dispute is soberingly real, and rooted in chains of events stretching back to 1274 and 1592. Although ostensibly about rights to possible undersea oil/gas reserves, the conflict is about more than territorial or mineral rights.

Japanese fear of Chinese domination can be traced back to the 1200s, when two massive fleets under Mongol leader Kublai Khan attacked Japan in 1274 and again in 1281. The four thousand-ship fleet carrying nearly 140,000 men is said to have been the largest naval invasion in history, eclipsed only in modern times by the D-Day invasion of France (Normandy landings) in 1944. The Mongol fleet was twice dispersed by timely typhoons known in Japan as the "divine wind" (kamikaze).

If you visit Korea, you will notice a curious repetition in the placard descriptions of the historic temples and palaces. Each description includes the phrase, "burned by the Japanese in 1592."

Hideyoshi, the feudal daimyo of Japan, seeking some project to occupy 200,000 battle-hardened samurai and soldiers who had been engaged in decades of feudal-fiefdom warfare in Japan, decided to invade Korea, an independent kingdom that paid tribute to Ming Dynasty China and was within China's sphere of influence.

The Japanese were not kindly conquerors. Not only did they put many of the national treasures to the torch, they destroyed crops, leading to widespread starvation and civilian death, and enslaved thousands of craftsmen who were shipped to Japan.

The Korean Navy managed to limit the invader's sea-supply chain, and eventually the Chinese Ming Dynasty entered the conflict to aid its Korean protectorate. The losses suffered by Korea were catastrophic, and the drain on the Chinese Imperial budget may have contributed to the decline of the Ming Dynasty, which fell in 1644.

There were actually two invasions separated by a brief Chinese-brokered peace. The war finally ended in 1598.

Japanese designs on Korea did not disappear, as Japan annexed Korea as a colony in 1910, a status that lasted until the end of World War II.

Though there is a lively trade between Japan and Korea, it is safe to say that the Koreans have not forgotten the brutal oppression they suffered under Japanese rule from 1910 to 1945, nor have they forgotten the needless destruction and civilian deaths resulting from the Japanese invasion of 1592. Even today, Koreans are second-class citizens in Japan, though you will be hard-pressed to get any official recognition of this reality.

China suffered greatly at the hands of the Japanese during World War II, when Japan invaded and occupied major swaths of coastal and northern China. The senseless, needless massacre of hundreds of thousands of unarmed civilians has been well-documented, though Japanese "Holocaust deniers" claim otherwise. The 1998 account of one city's experience, The Rape of Nanking: The Forgotten Holocaust of World War II, awakened many to the brutality of the Japanse occupation.

Though it is not acknowledged, the primary reason American troops remain stationed in Japan is not to protect Japan but to protect its Asian neighbors from Japanese aggression. This is also the reason American troops remain in Germany, 67 years after the end of World War II and two decades after the Soviet Empire collapsed. While the U.S. maintained an extensive military presence in Japan and West Germany as part of its defensive protection of the West from Soviet encroachment, the military presence also reassured nervous neighbors that the U.S. would limit the German and Japanese armed forces and cap those nations' aggressive tendencies.

This is why all the calls in Asia for the U.S. to reduce its presence ring hollow. Not only have people not forgotten Japanese aggression, they also haven't forgotten a thousand years of Chinese domination. The U.S. presence in East Asia reassures everyone in the region that neither Japan nor China will have a free hand to colonize, annex or otherwise dominate the region.

The Chinese people have a chip on their shoulder which they do not even see. The consensus view in China--once again, not spoken publicly, but real nonetheless--is that China's rightful place in the world is at the center (hence the term "middle kingdom," which actually means "center of the world"). Thus the entire world "should" recognize China's natural place at the head of the table, so to speak, and any other nation's resistance to this "natural order" (for example, America's) is seen as "they're trying to hold us back" rather than as an expression of national self-interest.

In other words, to the Chinese, it's always about China: whatever any other nation does, not just in Asia but anywhere on the planet, it's always "they're trying to hold back" China.

This smoldering chip on the shoulder has two sources: the humiliation of the 19th century at the hands of European and American colonial powers (imagine San Francisco being carved up and occupied by foreign nations, and you get a taste of Chinese resentment) and the aforementioned sense of dominance being the birthright of China.

Then there's the Asian focus on "face" that I discuss in China: An Interim Report: Its Economy, Ecology and Future (2005). Apparently The Japanese felt they lost face in last year's kerfuffle between a Chinese fishing boat and a Japanese patrol craft, and so "backing down" on the Senkaku Islands is not a domestic-politics option.

China's leadership, scheduled to change hands later in the year, is keen to avoid any public loss of face as well, as the last thing the leadership wants is any public perception of weakness against "Japanese aggression." One need only read The Rape of Nanking to udnerstand why it doesn't take much to incite mobs to trash every outpost of Japanese commerce within sight.

The Japanese have a peculiarly virulent strain of right-wing militarism that continues to influence domestic politics. In this worldview, reverence for the Imperial household is mixed with an aggrieved sense that Japan's expansion in World War II was justified (though few would say this publicly). As a result, any official Japanese attempt to apologize for the horrendous destruction, murder, enslavement and torture inflicted by Japanese forces in World War II sparks outrage in one sector of the domestic political order.

Deep within this mindset is the view that the only thing wrong with World War II was that Japan lost.

Even more galling to those who suffered so mightily, Japan has refused to publicly acknowledge (though they claim they have) and compensate the "comfort women," young women who were forced into prostitution to serve Japan's armed forces in the Asian/Pacific theater of World War II.

This official dance between apology and refusal satisfies no one, and the general sense outside Japan is that the Japanese acceptance of guilt is grudging public relations rather than sincere.

Combine an obsession with "face" and a plethora of deep-seated resentments, and you get the tinder for territorial disputes. What appears to be lost on the Chinese is the consequence of their saber-rattling and bluster: they appear to have obliterated 20 years of careful diplomacy aimed at convincing their neighbors of China's peaceful intentions.

What seems to be lost on the Japanese is the painful proximity of their World War II brutality in the awareness of their Asian neighbors.

As for solutions: one would hope there is a face-saving way to "engage in peaceful negotiations." If not, then this issue will fester. Though no one wants to state it publicly, there is a role for the U.N. as "honest broker" here, if only the participants can take their hands off their saber handles and practice a bit of honest self-criticism.

We are like passengers on the Titanic ten minutes after its fatal encounter with the iceberg: though our financial system seems unsinkable, its reliance on debt and financialization has already doomed it.We cannot know when the Central State and financial system will destabilize, we only know they will destabilize. We cannot know which of the State’s fast-rising debts and obligations will be renounced; we only know they will be renounced in one fashion or another.
The process of the unsustainable collapsing and a new, more sustainable model emerging is called revolution.Rather than being powerless, we hold the fundamental building blocks of power. We need neither permission nor political change to liberate ourselves. A powerless individual becomes powerful when he renounces the lies and complicity that enable the doomed Status Quo’s dominance.

Thank you, Rick E. ($5/month), for re-subscribing to this site-- I am greatly honored by your continuing support and readership.

Sunday, September 23, 2012

In a system that depends on lies and the credulity of the citizenry, the greatest lie is that the Federal Reserve's "quantitative easing" bailouts of the banks somehow help our citizens and communities.

To clarify this, ask yourself this question: what else could we have bought with the $29 trillion the Fed loaned or backstopped to the banks?

If you enjoy quibbling about the total sum of Fed support, be my guest; the Levy Institute came up with $29 trillion after poring over all the data, while the Government Accountability Office’s (GAO) tally topped $16 trillion. That's 100% of the nation's GDP and roughly 100% of the $16 trillion national debt.

While we're asking about opportunity costs, let's ask what else we could have bought with the $10 trillion that the Federal government has borrowed and blown in the past 11.7 years. The national debt was $5.727 trillion when G.W. Bush was sworn into office on January 20, 2001. It had risen to $10.626 trillion when President Obama was sworn into office in January, 2009. It is now $16.016 trillion, an increase of $5 trillion in less than four years in "debt held by the public" (i.e. the Chinese central bank, the Japanese central bank, the Federal Reserve, etc.)

$500 billion is roughly 3% of $16 trillion. That is rather astounding, isn't it? We could have switched to a (largely) solar-powered electrical grid for a mere 3% of what the Fed squandered to save the "too big to fail" banks. Yes, yes, I know we need a massive energy storage system for any solar-powered grid; shall we throw $1.1 trillion at the problem? That would total a mere 10% of what the Fed has provided to "save" crony-capitalist financial feudalism.

Correspondent S.H. (U.K.) has provided a community-centric, forward-looking alternative use of central-bank QE. Here are some excerpts from his essay Making Quantitative Easing Useful. I encourage you to read the entire essay, as it speaks to much more than what we could buy with the QE squandered on protecting financial feudalism. Though S.H. references QE in Britain (U.K.), the dynamics and opportunity costs are identical in the U.S. and every other nation burdened with the malinvestment of preserving a corrupt, exploitive, predatory neofeudalist financial system.

"Looking at the state of the country and the economy, then one has to say that we seemed to have gotten precious little out of such a massive mal-investment. In fact, the majority are actually worse off on account of the inflationary effects of QE and its negative impact on pensions, savers and working salaries.

So now we have institutions that talk about investment, that talk about growth, that talk about rebalancing economies, that talk about big societies, but then do absolutely nothing in order to engineer or bring the changes they propose about - as frankly - it-s just too difficult for their limited understandings.Let us be optimistic and not turn a drama into a crisis, but rather turn a dramatic crisis into a rather amazing transformational opportunity.Instead of being fearful and not engaging with the problems we face, we need to confront them and start thinking in new ways and generate some form of political, social and economic excitement.This is not socialism. Socialism is the mis-guided concept of a government centrally determining and engineering its population in their most narrowly conceived 'productive' form. Socialism sees humanity as something to engineer as a human resource or raw material for the dominating demands of industrial mass 'productivity'.Socialism tries to mass-produce its people on an industrial scale as just so many productive clones. I would reject this notion on the grounds that it is totalitarian and too restrictive. Instead of socialism I would rather pursue a politics that engenders and fosters sociability, co-operation and affability and a 'productivity' or even non-productivity conceived in all sorts of new ways.A big society needs big communities with great amenities. Instead of massive dubious crony capitalist infrastructure projects determined by national governments for the limited benefits of those few corporations large enough to take them on, each community could study their communities and democratically decide what amenities needed building and how they could be generally improved.If we decide we are interested in becoming fit and healthy then every community obviously needs excellent sporting facilities, so should have a gymnasium, all weather soccer pitches, basketball, tennis and squash courts, running tracks, cricket pitches etc. We need many more swimming pools.Each community also needs an infrastructure of useful buildings. An auditorium that can be used for community decision making, for theatre and for local musicians to perform in. Such buildings could also be used to hold wedding receptions and host other social occasions. They should be freely made available as temporary market places, or for martial arts instruction, music tuition, dance instruction, keep-fit and a host of other uses. Public recording studios, video studios, woodworking centres, and art facilities could all be put in place.We all have different skills and knowledge, yet we lack the sufficient community infrastructure to share our skills and teach one and other how to do things. How to grow your own fruit and vegetables and how to cook healthy and well balanced meals, how to draw and paint or make pottery, how to make films and documentaries, how to design electrical circuits or program chips, how to design, program, maintain and host web sites. The greater parts of our educations and knowledge is acquired outside of education systems and stem from researching and following our own particular interests.To be sure there a great many excellent videos published on the internet that can show you a lot, but its not the same as being shown in person when in addition to a social aspect of meeting people with similar interests, it is also possible to have points of difficulty clarified or allow for skills feedback where applicable.If we're going to print money then local authorities or even communities themselves can issue 30 year bonds which the central bank purchases, eventually to retire. Communities then start building their improved amenities using exclusively local companies labour and local firms buying all supplies locally. We have an opportunity to build ourselves a prettier, healthier, more co-operative and socially cohesive world and create many construction jobs that will make a real difference in the economics and quality of life within each community directly.Such an approach will also help recapitalize the banking system as all the money will eventually end up on deposit with banks as assets.In economic terms we need at least 100 public state of the art CAM (computer aided manufacturing) centres. As we all have computers and CAD (computer aided design) software is readily available, so in principle there is nothing to stop us from designing chairs, guitars, hose fittings, tables....the list is endless. With laser cutting machines, CNC routers, Object or 3D printers the technology is available for everyone to design and produce prototypes, objects for sale or for themselves. It's easy to design something, what is incredibly difficult in getting it into production.The potential for self-design and the realization of creative potentials is stunning. The technologies are all currently available to put this in place, we merely have to establish the infrastructure and means of transmission between systems.With 100 or more CAM centres to which the public could simply upload their CAD design s for one off or limited productions runs, we could release the amazing amount of national talent the we have always had by making it impossible for anyone not to be able to produce something.Whether their productions be commercial or for personal consumption or produced as gifts would not matter because a lot a great products will be designed and realized for larger scale production, based simply upon the law of averages. Such centres would also be available for schools where serious educational investments need to be made in the areas of engineering and design and technology. The more one is allowed to design the objects of one's own consumption, the more one is inclined to build more quality into the object and take much more pride and care of ownership of it as it is such a personal process that involves deep personal investments.At the same time, by making such investments then there are great rewards to be made in terms of the acquisition of new skills and knowledge and also in terms of creative self-achievements. This is productivity as a form of the consumption of the objects one produces and the self achievement and self determination that arises from being part of the whole productive process. We are all prototypes, waiting to construct ourselves and our worlds according to our own best desires, interests and wishes.In our current societies, as much as the objects that surround us also define us, then they are not of our own designs and making. Inevitably we live as kind of mass-produced consumer clones. As new technologies continue to develop and emerge that suggest that there is no reason for this to remain to be the case.With this new model, governments could set up centres for manufacturing and the people own the means of production, but one would be engaged within it freely on a democratic and completely ad hoc basis where one always becomes engaged and involved precisely around one's own particular aims and interests. This is to maximize satisfaction from the entire process of production from design and inception to its physical realization.Communities need facilities in order to grow and develop the kind of cohesive social bonds needed to move forward together. It is the task of governments at local and national levels to be the facilitators of such movements."

Thank you, S.H., for a thoughtful and thought-provoking exploration of central bank-supported loans for actual community development. Yes, it can be argued that some of these projects may be a "waste of money." Once again I ask: what did we get for $16 trillion? Did we get anything that actually aided citizens and communities? That the "too big to fail" banks have maintained their chokehold on the nation--how did that aid citizens and communities?

If the TBTF banks had been liquidated instead of "saved," the nation could have 500 regional banks that were liquid and well-regulated instead of a feudal "blob" that sets the agenda for the Fed and the machinery of governance.

The parasitic financial sector has looted the nation, and the Federal Reserve is the enabler of this predation. There are alternatives to crony-capitalist neofeudalism, if only we're brave enough and thoughtful enough to stop supporting our financial and political Aristocracies.

We are like passengers on the Titanic ten minutes after its fatal encounter with the iceberg: though our financial system seems unsinkable, its reliance on debt and financialization has already doomed it.We cannot know when the Central State and financial system will destabilize, we only know they will destabilize. We cannot know which of the State’s fast-rising debts and obligations will be renounced; we only know they will be renounced in one fashion or another.
The process of the unsustainable collapsing and a new, more sustainable model emerging is called revolution.Rather than being powerless, we hold the fundamental building blocks of power. We need neither permission nor political change to liberate ourselves. A powerless individual becomes powerful when he renounces the lies and complicity that enable the doomed Status Quo’s dominance.

Thank you, Lincoln F. ($20), for your much-appreciated generous contribution to this site-- I am greatly honored by your support and readership.

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